In Search of the Obvious

Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.
-- George Soros
One of the most interesting implications of this idea is that an investor is paid in the market not just for being correct--as most people think--but for being different. To make more money than average, you have to do something different from average. Being correct doesn't hurt, but being different is what pays the bills.

This is because most investors crave certainty and are willing to open their wallets for it, even if what they are getting is only the illusion of certainty. As a result, they almost always overpay for assurances about the future. This is exactly what Warren Buffett meant when he wrote that "you pay a very high price in the stock market for a cheery consensus."

Almost as a rule, investments that appear certain to succeed or market theses that seem certain to unfold are overvalued, while investments that have only a possibility of success are frequently undervalued--even if the potential payoff of the second group is far greater than that of the supposed "sure thing."

An exploitable anomaly, seemingly. So how can we put this idea of betting on the unexpected into practice?

Legendary hedge fund manager Michael Steinhardt used a mental model that he termed "variant perception." It sounds esoteric, but it translates roughly as "a different opinion."

In his autobiography No Bull, Steinhardt explains that he wanted his analysts to know four things about any investment opportunity:

1) the idea
2) the consensus view
3) the variant perception
4) a trigger event

This outline presents us with a strange challenge. How do we determine the "consensus view" on whatever subject we are looking for? In short, what is the "obvious"?

This may seem like a simple question to answer, and in many cases it is. In 1999-2000, it was obvious that internet stocks were going up. In 2005, it was obvious that home prices would rise forever. If it ever becomes obvious that stocks are going to go down forever, it will be time to buy them aggressively.

Still, when you apply the question to the flux of day-to-day market activity, it gets quite a bit more elusive. What is the "obvious" belief right now to be bet against? Bulls would say that everyone obviously expects the market to go down. Bears would say that everyone obviously expects the market to return to its previous highs.

To complicate matters further, the "obvious" belief may pointed in the right direction but not going far enough in that direction. For example, if it is obvious to most that we are in a mild recession (and it seems to be), the solution is not necessarily to buy stocks in anticipation of a recovery. It could instead be to batten down the hatches in preparation for a particularly bad recession.

All of this, combined with the seemingly weekly shifts in the consensus about what is "obvious," makes it a tricky time to be using this approach. Still, if the past is any guide, the markets will settle down into a new set of "no-brainer" ideas that we can then fade. I think we'll know them when we see them, but commodities and China seem set up to become good candidates at some point in the future.